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What has also caught our attention is that the economic growth in Europe appears to have stabilized and even begun recovering in some countries. German economic confidence recently surged to multi-year highs while the ISM manufacturing and services surveys across Europe beat expectations, rising to 47.7 from 46.9 and beating the estimate of 47.2. While still below the critical ‘50’ level in most of Europe, the surveys are now well off their lows and are showing that the 6-quarter recession might be ending this quarter. Moreover, if stock markets are a good lead indicator for economic conditions, then it has to be noted that while the German market was one of the best performing global markets in 2012, the top gainer so far in 2013 has actually been Greece! If the sickest patient looks to be healing, then it probably bodes well for the rest of the continent. While Europe will not be an economic powerhouse, all they need to do is show positive growth to keep the global economy on track.
The other big piece of the global economic picture is China. While commodity investors act like China is in the process of imploding, the numbers don’t support any such outlook. Granted that growth is slowing from the hyper-growth level of 2004-2007 and 2009-2011, the bottom line is that the second largest economy in the world continues to show annual growth in the 7-8% range! Investors were disappointed recently with the May PMI numbers, which dropped to 49.6 versus 50.4 in April, that data does not reconcile with what we are actually seeing in terms of physical data movement. Steel output rose to record levels last month, customs data showed gains in iron ore and coal imports of almost 20%, copper concentrate orders surged almost 80% and credit demand has been robust, with new loan growth up over 16%. These signs all suggest to us that China’s growth is not deteriorating. With the U.S. showing strength, Europe recovering, Japan on the mend with ‘Abenomics’ and China continuing to grow at over 7%, the global economic clearly looks to be gaining upward momentum.
This should be good news for Canada, which is more trade dependent than most, and should also help our stock market, which is tied closely to global economic conditions. While the U.S., German and Japanese stock markets have rallied in 2013 to multi-year highs, the Canadian stock market has been a major laggard, still more than 15% below its 2008 high and over 10% below the high reached in early 2011. The culprit keeping our indices down has been the resource sector, where the Basic Materials and Energy indices, which made up over 50% of our index at the peak, have performed miserably. That situation could be in the process of changing. Over the past month we have seen a noticeable pick-up in the performance of ‘cyclical’ versus ‘defensive stocks. The valuations of the two groups are at extremes, with defensive stocks getting high valuations due to their perceived safety, higher dividend yields and great interest rate sensitivity. Cyclical stocks, on the other hand, have seen their valuation collapse due to worries about slowing global growth, soft commodity prices and rising cost structures.
But so far this year, defensive sectors outperformance has not been validated by strong earnings reports. Quite to the contrary, EPS growth has been low single digits. This could represent the ‘first crack in the ice’ for the defensive sectors. Investors are paying 17.1x to own defensive stocks while only paying 13.7x for late cyclical stock groups such as industrials, technology, basic materials and energy. Moreover, this 25% valuation premium can hardly be justified by defensives’ superior dividend yield, which is now 3.0% versus the cyclicals at 2.5%. Therefore, with valuation stretched, it seems that globally geared defensive stocks are losing their margin of safety relative to the rest of the stock market. Any change in this relative performance should put Canadian stocks back on the radar screens of foreign investors. However, we still have the Gold Sector to contend with and that has the single biggest drag on the Canadian market over the past year.
The recent tug-of-war in the gold market has been between the huge holders of the Gold ETF (Exchange Traded Fund) and the buyers of physical gold in emerging market economies as well as by central banks. The ETF sellers, by virtue of their much larger size and huge gains over the past ten years, have been winning the battle so far in 2013. Those assets reached a peak of 2,632 tons in last December but sales of over 455 tons so far this year have driven those assets back down to a level of 2,177 tons. The liquidation of the Gold ETF so far in 2013 exceeds the total purchases in 2011 and 2012 combined. Clearly this trend could continue as ‘hot money’ exits the trade and investors move assets back into the U.S. dollar. But the buying of physical gold in China and India is an interesting offset to these sales. Also, as shown in the chart below, the short position in Gold futures contracts on commodities exchanges has reached an 8-year high. With so many traders positioned for a further downward move in prices, this has become a ‘very crowded trade,’ meaning that it often ends up going in the opposite direction to where the majority of traders are positioned. The last time that short sales reached such a peak (in 2005), gold was trading below US$500 per ounce. One year later, it traded over US$700, a 40% gain. Let the contrarians beware!
